My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Thursday, January 2, 2014

A good year ends, but what's next for stocks?

As an exceptionally good year for stocks comes to an end, the talk of stock market bubbles fills the air. Among others, Robert Shiller warns us, that based upon his market measure of value, that we are in "bubble" territory and almost every acquaintance that I have starts off by asking me whether I think that US equities are ready to pop. I have great respect for Shiller, but I also know that the market is bigger than any of us, Nobel prize winners or not. As the the new year begins, and we all turn our attention to the state of our portfolios, I am sure that this discussion will only get louder. You may be accuse me of being "chicken" but I am loath to get into this guessing game, since market timing is not my strength. However, the scattered nature of the debate, where each side (bubble or no bubble) finds something in the market that supports its thesis reminds me of the story about the blind men who are allowed to touch an elephant and come to very different conclusions about what it looks like. Perhaps, the only contribution I can make to this discussion is to provide a framework that can be used to make sense of the different perspectives on the future of stocks and at lease provide some perspective on how investors can look at the same numbers and come to such different conclusions.

Standard Pricing Metrics: In the eye of the beholder?

Most of the arguments about whether we are in bubble territory still are built around the standard metrics, where equity multiples are compared across time and markets. In fact, a surprisingly large number of arguments, pro and con, are based on the PE ratio, with variants on earnings used by each side to make its case. Those who remain optimistic about the market focus on trailing or forward earnings and note that the trailing and forward PEs, while high can be explained by low interest rates. Those who are pessimistic about markets either make their comparisons to the historic averages for the PE ratio for the market or argue that earnings for the market are high today (in both absolute levels and stated as a percent of revenues) and are ripe for adjustment. Thus, it is no surprise that those who use cyclically-adjusted PE (CAPE) are sounding alarm bells about the market.

Valuing the market

Like any other investment, the value of a market is determined by cash flows, growth (level and quality) and risk in stocks. Consider an investor who buys the equity index. That investor can lay to claim to all cash paid out by the companies in the index, composed of both dividends and stock buybacks. If we forecast out these composite cash flows, the value of the index in intrinsic terms can be stated as a function of the following variables:

Given these drivers of equities, where do we stand right now? The S&P 500 starts the year (2014) at 1848.36, up almost 30% from it's level of 1426.19, a year prior. While that jump in stock prices makes most investors wary, it is also worth noting that the cash paid out to equity investors in the twelve months leading into the start of 2014 amounted to 84.16, up 21.16% from the cash flows to equity in the twelve months leading into the start of 2013. As the economy strengthened over 2013, the US treasury bond rate also climbed from 1.76% at the start of 2013 to 3.04% at the close of trading on December 31, 2013. To estimate the cash flows in future years, we used the estimates of earnings from analysts who track the aggregate earnings on the S&P 500 (top down estimates), resulting in an earnings growth rate of 4.28% a year for the next five years, which we also assume to be the growth rate in the cash flows paid out to equity investors (thus keeping the payout stable at 84.13% of earnings). As a final input, we set the growth rate in cash flows beyond year 5 at 3.04%, set equal to the risk free rate.

The simplest way to bring these numbers together is to look for a discount rate that will make the present value of the cash flows (i.e., the intrinsic value of the index) equal to the traded value of 1848.36. That discount rate works out to be 8.00% and can be viewed as the expected return on equities, given my estimates of cash flows. Netting out the risk free rate from that number yields an implied equity risk premium of 4.96%.

Are we in a bubble?

One way to evaluate whether stocks are collectively misplaced is to compare the implied equity risk premium today to what you believe is a reasonable value. That "reasonable value" is clearly up for discussion but to provide some perspective, I have reproduced the implied equity risk premiums for the S&P 500 from 1961 to 2013 in the figure below.

The equity risk premium of 4.96% is clearly down from its crisis peaks (6% or higher), but it is still higher than the average of 4.04% from 1961-2013 and slightly above the average of 4.90%, from 2004-2013. Market optimists would point out that unlike the market peak in early 2000, when the implied equity risk premium of 2.00% was well below the historic norms, the equity risk premium today is at acceptable or even above acceptable levels. Market pessimists, though, will note the equity risk premium in September 2008 was also just above the historic norms and that it provided little protection against the ensuing crash.

Stress Testing the Market

The assessment of the equity risk premium above is a function of the risk free rate and my estimates of expected cash flows and growth. Since all of these can and will change over 2014, it is prudent to evaluate which of these variables pose the greatest threat to equity investors.

1. Risk free rate

While the US T.Bond rate has rebounded from its historic lows, it remains well below its norm, as indicated in the figure below:

While there are many who attribute the low rates in the last few years primarily through quantitative easing by central banks, I remain a skeptic and believe that low economic growth was a much bigger contributor. In fact, as economic growth rebounded in 2013, interest rates rose, and if expectations of continued growth in 2014 come to fruition, I believe that rates will continue to risk, no matter what the Fed decides to do. While that rise in rates may seem like an unmitigated negative for stocks, the net effect on stocks will be a function of whether the economic growth also translates into higher earnings/cash flow growth. It is only if interest rates rise at a much steeper rate than earnings growth rates increases that stocks will be hurt.

2. Equity Risk Premium

While the equity risk premium today is not low, relative to historic standards, the last five years have taught us that market crises can render historic norms useless. Thus, there is always the possibility that 2014 could bring a macro crisis that could cause equity risk premiums to revert back to 2009-levels. In the following table, I estimate the intrinsic value for the S&P 500 at different equity risk premiums.

If, in fact, we saw a reversal back to the 6.4% equity risk premiums that we observed after the crash, the index would be valued at 1418, making it over valued by about 30% today.

3. Cash flows

It is clear that US companies returned to their pre-crisis buyback behavior in 2013 and there are some who wonder whether these cash flows are sustainable. To answer that question, we looked at dividends and buybacks from 2001 to 2013 in the figure below, and compare them to the earnings on the index each year.

Are US companies returning too much cash to investors? It is true that the 84.13% of earnings paid out in dividends and buybacks in 2013 was higher than the average of 79.96% from 2004-2013, but the difference is not large. The bigger danger to cash flows to equity is a collapse in earnings. In fact, using the CAPE rule book, we estimated the inflation-adjusted earnings on the index each year from 2004 to 2013 and computed a ten-year average of these earnings of 82.64. Applying the average payout ratio of 79.96% to these earnings results in a much lower cash flow to equity of 66.08. Using those cash flows, with an equity risk premium of 4.90%, results in an intrinsic value for the index of 1467.89, about 20.6% lower than the index level on January 1, 2014. Thus, it is no surprise that those analysts who use PE ratios based on average earnings over time come to the conclusion that stocks are over priced.

4. Growth Rates

The use of analyst estimates of growth can make some of you uneasy, since analysts can sometimes get caught up in the mood of the moment and share in the "irrational exuberance" of the market. While using top down estimates (as opposed to the estimates of growth in earnings for individual companies), provides some insulation, there is a secondary test that we can use to judge the sustainability of the predicted growth rate. In particular, when the return on equity is stable, the expected growth in earnings is a product of the retention ratio (1- payout ratio) and the return on equity:

Sustainable growth rate = (1 - Payout ratio) (Return on equity)

Using the 84.13% payout ratio and the return on equity of 15.790% generated by the market in 2013, we estimate an expected growth rate in earnings of 2.67%, lower than the analyst estimate of 4.28%. Substituting in this growth rate lowers the value of the index to 1741, making it over valued by about 6%, at its current level.

Try it yourself

I know that you will probably have your own combination of fears and hopes. To help convert those into an intrinsic value for the index, I have the spreadsheet that I used in my analysis for download. When you open the spreadsheet, you will be given a chance to set your combination of the risk free rate, equity risk premium, cash flows and growth and see the effect on value. The spreadsheet also has historical data on risk free rates and equity risk premiums embedded as worksheets.

Bottom Line

As I look at the fundamentals and the possibilities for 2014, I am wary but no more so than in most other years. There are always scenarios where the intrinsic value of the index will drop and the biggest dangers, as I see them, come from either a global crisis that blindsides markets or from a precipitous drop in expected earnings. Can I guarantee that these scenarios will not unfold? Of course not, and that is precisely why I would require an equity risk premium for investing in stocks and will continue to diversify across asset classes and markets. You may very well come to a different conclusion, and whatever it is, I wish you only success in the coming year, even if it comes at my expense. Happy New Year!

Your calculations are 1000x more valuable than pundits chattering on financial news channels. Thank you the insightful article!

I guess the crux of your argument is: You need to assume "five years of abundant growth" to make the index fairly priced. Also: Any broad disruption to the economy, a cyclic recession or a deeper one, will probably make the index overpriced.

Wonder if we can quantify any of these statements. Is there a simple model to factor in the effect of a mild or severe recession on earnings? Not sure how the bounce-back can be modeled. I'd be interested in hearing your thoughts. Thanks.

A question on the Indian market: I noticed your calculation of implied risk premium (in Sept 2007) where you used a dividend yield of 3.05%. However, dividend yields from Indian markets have usually been quite low (less than 2%) and buybacks are not that common. Can you please let me know how you based your dividend yield? It will be helpful for my current and future analysis. Thanks.

On the question of five years of growth, I set it up only to provide myself with flexibility. Thus, the growth rate in the first five years can be set equal to the growth rate in perpetuity, making it a stable growth model. It can be set lower than the rate on the economy, which is the case with the fundamental growth rate of 2.4%. It can be set higher, as I have, though not by much.If you are worried about a recession, it is best not to try to work it into the growth rate but to decrease the base earnings. Thus, using the ten-year average earnings works out to a drop of about 25% in earnings, which is the equivalent of a severe recession.

hi Prof, thanks for your valuable insight as always. As asked by anonymous above on indian markets, my question pertains to growth markets in general where dividend (& cash) payout is less. how do we look at index valuations in such markets?

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1. Given the uncertainty in the ROE and retention ratio for 2014, IMO, anything less than 10% plus or minus vs. the starting value for the S&P is probably fair value. I would submit the same it true for all valuations however they are done.

2. Some nitpicking. When I multiplied the retention ratio of 15.87% times the ROE of 15.79% I get 2.51%. It makes no difference in your conclusions.

The only little problem relates to margin sustainability.....they're currently at an all time high in history....being 70%+ above norm....maybe that's partly fair.....but it induces a lot of risks to forward normalized earnings in the model (that is, the starting level of the progression is probably too high).....the other point is the level of risk free rate (and, as a consequence, the implied ERP)....how much is a market rate today and how much has it been manipulated by policymakers??.....I'm terribly worried long term, and really think at current level the prospective compound return for the next 7-10 years can be really paltry

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A question for you to consider. If companies distribute 84% of earnings through dividends and buybacks. That means 16% is re-invested to generate growth. A return on equity of 13.4%, would imply a growth rate of 2.14%. This is somewhat shy of the growth estimate you are considering. Basically, what I am saying is that an 84% payout of as reported earnings (estimate $96.72), gives a return of 5.26% based on a market trading at roughly 1,840). Add to that 2.14% growth, and a return potential of 7.4% results. A long-term return expectation of 8.5% would imply the market is rightly valued closer to 1,500.

Valuation conundrum with respect to several 50% subsidiaries which are consolidated in a company.

I note that seemingly all the analysts on the street proportionally consolidate the 50%EBITDA in their DCF but then deduct the full debt consolidated by the company from their EV in arriving at an equity value.

I see in the comment from an earlier post that you addressed this issue via one suggested method, which was looking at it from the reverse perspective of deriving an EV from equity value:

"The market value of equity in the parent company reflects only the majority stake in the subsidiary but the debt and cash in the computation are usually obtained from consolidated balance sheets, which reflect 100% of the subsidiary. To counter this inconsistency, analysts add the minority interest (which is the accountant's estimate of the equity in the non-owned portion of the subsidiary) to arrive at enterprise value, but the minority interest is a book value measure."

So in my example, yes, 100% of the debt is consolidated, but is this treatment too punitive on the resultant equity valuation given the DCF modelling only recognises 50% of the EBITDA?

Could you not, in this example, lodge an argument for deducting 50% of the debt so it is consistent with the earnings treatment (particularly if neither parent/subsidiary/other 50% owner is under any debt distress)?

My own intuition, suggests the "fairest" treatment is somewhere in between, although this is difficult to justify on theoretical valuation grounds.

re:"While that rise in rates may seem like an unmitigated negative for stocks..":Historically we find that rate increases are a boon to stocks, not a negative. Why? They correlate with increasing growth expectations, thus inflating multiples. If you view the world through a Gordon growth model lens, the influence of increasing growth overwhelms the depressing effect of a higher discount rate.

Thank you for an excellent article and for breaking down your methodology so cleanly and transparently.

My question is on the validity of using analyst consensus earnings estimates. Is there any reason to believe that they are reliable?

I have tried in vain to find some hard data on this (would love to find a series of consensus estimates for earnings growth, compared to the actual earnings growth that occurred, but cant' find it). One money manager I respect, GMO, has stated that historically analyst estimates have overstated subsequent reality by a factor of 2x.

So I'm inclined to give a haircut to the analyst consensus E growth estimates, but I'm not sure how much. Do you have any insights?

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Aswath,I wish you would comment on the market's valuation more frequently. You only do it sporadically, and ditto for Fernando Duarte. Since I am of the opinion that the ERP is the gold standard of equity analysis, I need more frequent guidance from the gurus.

This is an excellent article :) Thanks for sharing! I would like to ask a question. You 've wrote that if ROE stays stable the growth rate only depends on the retention ratio. Maybe I've lost it but which metric is used to measure the growth exactly? Net income, FCF, cash flow, net change in cash? How about acquisitions, capex in general, the purchase of short term investigations, don't these affect the growth of the business, or they're included in your calculation?

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